Island Investing: Shenanigans

Q. How can I tell if a company is playing games with its financial statements?

A. You may be the kind of person who likes to dabble in stocks. Perhaps you buy a few shares without doing research just because it gives you a thrill. Or maybe you have a small amount to invest and can’t see the point of putting in 40 hours of research to buy $50 worth of shares.

While I don’t want to discourage anyone from investing in stocks, one of the prerequisites should be that you understand how to read a company’s financial statements. If you don’t, that’s a pretty good sign you need some help when investing. If you can read the financials, there are a handful of things you can check fairly quickly that will help identify certain red flags. Below are seven of them. They are not fool-proof ways to spot fraud by any means, but they can be useful in abbreviated reviews.

1. A company’s earnings should be consistent with its operating cash flow. The two won’t be equal but they should move in the same direction and to a similar degree. Watch out if earnings grow much faster than cash flow for an extended period of time.

2. Be skeptical if current assets other than cash are growing. Keep a close eye on increases in inventories and/or accounts receivable compared to sales.

3. Make sure you understand the rationale behind any impairments or write-offs that are particularly large or recurring.

4. Any accounting policy changes should be explained simply and in a straightforward manner.

5. Depreciation and amortization practices should be consistent among competitors. Deferring these expenses over longer than usual periods of time is one way to artificially inflate profits.

6. Watch for dramatic changes in reserves against bad debt. This can signal deterioration in the quality of current assets.

7. Understand how the company makes money. If you can’t explain this to a five-year-old, it may be a fairly complicated business – and that could mean there is more room for management to play games with the financial statements.